The Issue of Inflated High-Risk Debt in European Banks

The Issue of Inflated High-Risk Debt in European Banks

Banks within the European Union may be overestimating the value of high-risk debt utilized to fill holes in capital buffers designed to offer protection during financial crises, according to the EU’s banking watchdog. The issuance of Additional Tier 1 (AT1) bonds, also referred to as contingent convertibles or CoCos, has become a popular strategy for banks to enhance their capital levels post the global financial crisis. These bonds have the ability to convert into equity or be completely written off if a bank’s capital falls below a certain threshold.

Recently, there have been conflicts between buyers of such debt and banks, particularly highlighted by the situation at Credit Suisse where AT1 debt worth approximately $17 billion was written off entirely due to the bank’s merger with UBS. The European Banking Authority (EBA) conducted an investigation into the issuance of AT1 bonds and released a report outlining its findings. The report included new templates aimed at standardizing information to provide a more accurate assessment of the bonds’ value.

The EBA expressed concerns about potential discrepancies between the ‘carrying’ value of the bonds as recorded on a bank’s balance sheet under accounting rules and their ‘nominal’ value. The focus is on ensuring that capital instruments accurately reflect their actual loss absorbency capacity for the calculation and reporting of regulatory capital ratios. The EBA highlighted the need for better clarity in the wording of provisions to avoid uncertainty regarding regulatory requirements and to reduce the complexity of the instruments.

Industry experts, such as Chris Woolard from EY, emphasized the significance of regulators evaluating the level of capital accessible to banks during financial distress. Woolard suggested that the banking sector is likely to face further investigations in the near future, with stakeholders seeking greater standardization across the industry. Moody’s associate managing director, Simon Ainsworth, supported the idea of a standardized and conservative approach to valuing AT1 bonds, citing benefits such as enhanced transparency, reduced legal risks, and increased investor confidence.

While the European Central Bank refrained from commenting on the matter, regulators worldwide are reviewing the implications of the events at Credit Suisse and considering potential changes to the use of AT1 bonds in capital buffers. The Basel Committee of banking regulators has acknowledged the need to assess the complexity, transparency, and comprehension of AT1 bonds following the upheavals in the banking sector, notably involving Credit Suisse.

The EBA’s report sheds light on the potential issues surrounding the valuation and issuance of high-risk debt by European banks. The importance of accurate and standardized assessments of capital instruments, such as AT1 bonds, cannot be understated in ensuring financial stability and investor confidence within the banking sector. Regulators and industry participants must work together to address these concerns and implement measures that promote transparency, consistency, and sound risk management practices in the financial system.

Economy

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